Saving The World From The Economists: Ronald Coase &amp; Paul Krugman

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

John Maynard Keynes

“The degree to which economics is isolated from the ordinary business of life,” writes Nobel Prize winner Ronald Coase in the December 2012 issue of Harvard Business Review in an article entitled, Saving Economics from The Economists, “is extraordinary and unfortunate… Economists write exclusively for each other… giving up the real-world economy as their subject matter… The tools used by economists to analyze business firms are too abstract and speculative to offer any guidance to entrepreneurs and managers in their constant struggle to bring novel products to consumers at low cost.”

Economics, writes Coase, as currently presented in textbooks and taught in the classroom does not have much to do with business management, and still less with entrepreneurship.

Lost opportunity or positive harm?

Coase sees the problem as one of lost opportunity: economics is not having the influence that it should. Sadly, society is therefore being deprived of the contribution that these fine minds might otherwise make.

If the only problem of economists was one of irrelevance, then we could view the exchanging of econometric models of largely irrelevant issues by academics in ivory towers with the same nonchalance that we view medieval theologians arguing about how many angels can dance on the head of a pin.

The sad reality is that the people do pay attention to economists and their models. Although it’s true that the tools used by economists to analyze business firms are too abstract and speculative to offer any useful guidance to entrepreneurs and managers, this doesn’t prevent them being used, with devastating negative effect in the real world.

Contrary to the dictum of John Maynard Keynes, economists don’t have to be defunct to cause a lot of problems in the real world.

The case of Paul Krugman

One economist who has ventured out into the public domain is Paul Krugman. No longer cloistered with his academic confreres, Krugman writes a bi-weekly column for the New York Times and makes his progressive political stands explicit. As an enemy of greed that he sees as pervasive in business today, Krugman uses economic findings to promote his political agenda.

According to Margaret Sullivan of the New York Times, writing about his appearance at recent event, "Mr. Krugman, of course, is not only a Nobel laureate, but also a rock star among the wonkish set; his presence lent the event gravitas and credibility. (One of his first questions from the audience came from a woman who thanked him effusively for his presence and gushed that she felt like 'a 13-year-old at a Justin Bieber concert.')"

Maybe it's a consequence of becoming a rock star, but Professor Krugman's columns tend to oscillate between striking insights and infuriating loopiness.

The article contains an interesting insight: a study by the Bureau of Labor Statistics (BLS) shows that labor share of non-farm business sector output is down from 67 percent in 1947 to 58 percent in 2010. This ties in with the perceived reality of working class people today: it is getting harder and harder to make ends meet.

Something must be done. But what? Krugman suggests four practical conclusions flowing from the BLS finding.

Firms are making excess profits: “Corporate profits are at a record high. How is that possible? … The finance guys are still making out like bandits — in part because, as we now know, some of them actually are bandits.”

Anti-trust enforcement should be strengthened: “Antitrust enforcement largely collapsed during the Reagan years and has never really recovered. Yet … increasing business concentration could be an important factor in stagnating demand for labor, as corporations use their growing monopoly power to raise prices without passing the gains on to their employees.”

Corporate tax rates should not be lowered: “There is a big, lavishly financed push to reduce corporate tax rates; is this really what we want to be doing at a time when profits are surging at workers’ expense?”

Distributional issues between classes of workers are no longer relevant: “What many people thought; for the past generation discussions of inequality have focused overwhelmingly … on distributional issues between workers, either on the gap between more- and less-educated workers or on the soaring incomes of a handful of superstars in finance and other fields. But that may be yesterday’s story. “ Instead, says Krugman, we should focus on doing something about the firms that are “making out like bandits.”

The logic driving these conclusions is less rigorous than one might expect from a Nobel Prize winning economist. Let’s look at each of them in turn.

Firms are making excess profits?

Are firms making excess profits? The truth is that, if we look at the long term trends, firms are finding it more and more difficult to make money. The Shift Index study of 20,000 US firms from 1965 to 20011 shows that the ROA and ROIC have declined by 75 percent.

Yes, corporate profits are currently high in a period of low economic growth. But that’s because large firms have access to free money, courtesy of the Federal Reserve. The free money is like life support. It keeps the economy out of recession, but it doesn’t lead to economic health. The real driver of economic growth and employment—small and medium enterprise—have no such access to free money and so the economy is still in the Great Stagnation following the 2008 financial crisis.

Thus the current level of comfortable profits is ephemeral and artificial: if the Fed were to stop providing the economy with life support by way of free money to big business, these profits would disappear overnight. In other words, nothing structural can be inferred from the current level of business profits. It’s wrong to conclude that the private sector is flourishing. In fact, the private sector faces deep structural problems that have yet to be addressed.

Anti-trust enforcement should be strengthened?

Similarly, Krugman’s argument for strengthened anti-trust enforcement is weak. Data shows that firms are dying faster and faster. The life expectancy of a firm in the Fortune 500 is now less than fifteen years and declining rapidly. The topple rate of leading firms is accelerating. Thus there is no general need for strengthened anti-trust enforcement. The market is being more effective than any anti-trust action could be.

Corporate tax rates should not be lowered?

Krugman’s opposition to changes in the corporate tax rates similarly lacks justification. The problem with current corporate tax rates is not that they are too low but they are totally arbitrary. As a result of loopholes, hardly any large firm pays the nominal rate. Some like GE pay no tax at all. Rationalization of tax code is urgently required.

Distributional issues between workers are "yesterday’s news"?

Similarly, Krugman’s suggestion that distributional issues between classes of workers is “yesterday’s news” is hard to reconcile with obvious facts.

For instance, last year Tim Cook received stock grants, which vest over a 10-year period, that at today’s share price would be worth more than $500 million, while 30,000 of the 43,000 Apple employees in this country who work in Apple Stores, earn about $25,000 a year.

The difference between $500 million and $25,000 is significant and one can understand the moral outrage that such discrepancies engender. What meat does Tim Cook eat that could conceivably warrant compensation of $500 million? Would $200 million be enough to get Mr. Cook out of bed in the morning and turn in a day’s work for Apple? $100 million? Or even a measly $10 million?

There is cause here for serious concern. But the gap is between different workers, not between the employer (Apple) and its workers. As it happens, Apple is also getting huge benefits. But it is the exception. Most employers are not doing nearly so well. Overall, compensation of the C-suite of big firms is now inversely related to corporate performance.

By portraying this is as a capital vs labor issue, Krugman downplays the giant financial incentives bubble that is distorting the economy so badly.

The real news: the compensation/productivity gap

In fact, Krugman misses the real news in the BLS study, which is table six. It shows that it isn’t always true, as Krugman suggests, that “profits have been rising at the expense of workers in general.”

Table six of the BLS study shows that there is a problem but it isn’t pervasive throughout the period from 1947 to 2010. In fact, it began around 1980.

Between 1947 and the mid-1970s, growth in real hourly compensation kept slightly ahead of productivity growth in the manufacturing sector.

From 1980 to 2010, the situation changed: productivity continued its upward trend, whereas real hourly compensation growth was relatively flat. In other words, the divergence didn’t happen in the last few years, or over the entire six decades in question. It happened over the last three decades only.

What could have caused the gap to occur? As it happens, the growing gap coincides with the emergence of shareholder capitalism around 1980 when executives started being awarded stock as compensation and the great financial incentives bubble for executives and the financial sector began to grow.

Coincidence doesn’t prove causality, but it certainly deserves to be explored.

Rather than attacking corporations as “bandits” and suggesting higher taxes and strong anti-trust action, Krugman might better spend his powerful economic mind exploring the causes of the gap between productivity and labor compensation in the last three decades and the likely connection with shareholder capitalism.

Krugman might for instance turn his attention to the 1976 economic study by Meckling and Jensen, which provides the intellectual underpinnings of the shareholder capitalism movement and explore whether it is soundly based.

The deeper cause of the problem: Coase’s theory of the firm

Ironically, the deeper cause of these problems may lie with the economic work of Coase himself, whose writings form the basis of the current economic theory of the firm. Firms exist, Coase wrote, because they reduce transaction costs. This theory won Coase the Nobel Prize in economics. It has contributed to the continuing focus in business on cost-cutting and efficiency, while short-changing the ever more pressing need today to add value for customers. Far from being irrelevant to business, as Coase argues in HBR, economic theories play a key role in creating the intellectual foundation for it.

What we need now is a new economic theory of the firm that includes an appropriate emphasis on adding value for customers, not just on efficiency and cutting costs. If Professor Krugman were to turn his attention to that, with some serious economic analysis, instead of merely berating corporations as “bandits”, he could well deserve a second Nobel Prize.